Derivatives exchanges owe much to wise regulation

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There has long been a whiff of ignominy attached to securities whose values were “derived” from something else. Something real, like a stock or a bond. As my dictionary snorts, a thing that is “derivative” is banal, lacking originality.

Derivatives exchanges—those hawking futures and options—have long been backwoods beasts in the US. Relegated largely to the Midwest, their product range comprises an uncomely combination of the base (frozen pork bellies) and the barmy (Des Moines November heating). Yet they dominate the headlines like never before.

The critical and positive role of derivatives in the financial markets and the wider economy has not been fully appreciated by the public. The futures and options markets performed far more efficiently than the stock market during the 1987 crash. Innovation in securitisation in the 1990s, particularly in the mortgage market, resulted in a more robust banking industry than the one that teetered into the savings and loans crisis of the late 1980s.

The story of the past 10 years has been the rise of exchange-traded derivatives. While still considerably smaller than the interbank over-the-counter market, which accounts for 83 per cent of derivatives trading, the exchange-traded derivatives business is in the midst of a remarkable renaissance. From 2000 to 2005, average annual growth in the notional value of derivatives contracts outstanding was 32 per cent in the exchange market, compared with 23 per cent OTC. Exchanges are now challenging banks for business in the traditional OTC space. The Chicago Mercantile Exchange has, in the past year, moved aggressively in marketing clearing services for OTC products and is believed to be shopping actively for a major inter-dealer broker one of the exchange-like trading firms widely used by hedge funds. Assuming the CME's takeover of the Chicago Board of Trade passes antitrust scrutiny, it will have by far the largest market capitalisation of any exchange in the world, about twice that of the New York Stock Exchange Group.

For those who wonder whether the Chicago behemoth will soon try to swallow up the likes of the NYSE or Nasdaq, the answer is almost certainly no. From 2000 to 2005, CME's annual growth in contracts traded averaged 36.4 per cent, compared with NYSE share-trading growth of 14.5 per cent. The CME's product base is huge and expanding rapidly, encompassing futures on commodities, equities, energy, foreign exchange, interest rates, weather, real estate and economic statistics. Future growth in the derivatives markets is limited only by imagination there are always new and valuable ways to slice and reallocate economic risks. By comparison, stocks are a slow-growth business, constrained by natural limits to the annual supply of new listed companies and investor demand for equities.

Overlooked in the CME's rise has been the role of enlightened regulation. The US Commodity Futures Trading Commission, with great foresight and political courage, instituted its so-called “no action” regime for foreign exchanges in 1996. While fiercely opposed by Chicago's then mutualised, floor-dominated exchanges, this regime introduced much needed electronic competition from abroad, particularly from Frankfurt-based Eurex, and deserves most of the credit for stimulating the enormous reforms in ownership, governance and market structure that were essential to the CME's revival. Demutualisation has transformed the CME from a staid broker-dealer utility into a fierce and creative competitor to banks and exchanges alike. The CFTC's recent decision to allow ICE Futures, regulated by the UK Financial Services Authority, to continue to compete with Nymex in the US energy futures market under the “no action” regime represents another boon for the expanding ranks of American exchange-traded derivatives users.

Regulators have generally welcomed the entry of exchanges into the OTC derivatives space, as exchange clearing houses bring big cost reduction and risk reduction benefits to derivatives markets participants. But centralised clearing, in turn, concentrates risk in a single institution in such a way that its failure could be a source of systemic risk, nationally and cross-border. Monitoring the operations of cross-border clearing houses will therefore require an unprecedented level of international regulatory co-operation, as this is one form of risk, unfortunately, that cannot be mitigated with derivatives.

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